Product Pricing

CBBCs have a “theoretical value” that may be very different from their traded (nominal) price. The theoretical value is the price of the CBBC calculated by reference to the issuer’s pricing model, taking into account all relevant market factors.

During the term of a CBBC, its price will be influenced by a number of factors, including:

(a)  its strike price or level and call price or level;

(b)  the likelihood of the occurrence of a mandatory call event;

(c)  the probable range of residual value (if any) upon the occurrence of a mandatory call event;

(d)  the funding cost;

(e)  time remaining to expiry;

(f)  the interim interest rates and expected dividend payments or other distributions on the underlying asset;

(g)  the liquidity of the underlying asset;

(h)  the availability of, and demand for, the CBBC;

(i)  the probable range of the cash settlement amount;

(j)  the issuer’s related hedging transaction costs;

(k)  the creditworthiness of the issuer and its guarantor, if applicable; and

(l)  in the case of index CBBCs, the price and liquidity of the futures contracts relating to such index.

The price of a CBBC tends to follow closely the price of the underlying asset. As a result, if the underlying asset increases in value, a “bull” CBBC with an entitlement ratio of 1 to 1 (i.e. one CBBC to one unit of the underlying asset) generally increases in value by approximately the same amount, whereas a “bear” CBBC with an entitlement ratio of 1 to 1 generally decreases in value by approximately the same amount.

However, when the underlying asset of a CBBC is trading at a price close to its call price, the value of CBBC may become more volatile (and less sensitive to movements in the price of the underlying asset due to the risk of occurrence of a mandatory call event) and the change in its value may be disproportionate to the change in the value of the underlying asset.

The funding cost of a CBBC is relevant to determining its price. A CBBC is generally traded at a price that represents:

(a)  for bull CBBC, (spot price or level of the underlying asset - strike price or level of the CBBC) + prevailing funding cost; and

(b)  for bear CBBC, (strike price or level of the CBBC - spot price or level of the underlying asset) + prevailing funding cost.

The funding cost is determined based on:

(a)  an issuer’s financing or stock borrowing costs, after adjustment for any expected ordinary dividends of the shares (if the underlying assets are dividend-paying shares); and

(b)  its profit margin.

These items fluctuate from time to time. The funding cost of a CBBC may be affected by its supply and demand. Furthermore, depending on the liquidity and volatility of the underlying asset at the time, the cost and risk of hedging may also cause a fluctuation in the issuer’s funding costs. This means that the issuer’s funding costs are not fixed throughout the term of the CBBC. In addition, the longer the duration of the CBBC, the higher the funding costs. The funding costs decline over time as the CBBC moves towards expiry.

“Outstanding quantity” means the quantity held by investors and is generally shown as a percentage. It is calculated by dividing the number of CBBCs held by the market on a particular day (after closing) by the total number of CBBCs issued. For example, if the number of certain CBBCs held after closing on a particular day is 90 million and the number of those CBBCs that had been issued is 100 million, then the outstanding quantity is 90%.

A product with a high outstanding quantity may be more vulnerable to the influence of the forces of market supply and demand. For example, when there is a selling pressure on a product, the price of that product may be squeezed (that is, brought down) by prevailing market forces. The price of the product may also be volatile due to short supply. As a result, its price may not follow the price of the underlying asset very closely.

Issuers are entitled to increase market supply of a CBBC where the outstanding quantity exceeds 50%, to prevent price fluctuations caused by short supply. The way this takes place is that the issuer applies to the Exchange for a further issuance of the CBBC.

The entitlement ratio for a CBBC is the number of such products required to be converted into a unit of the underlying asset at the strike price on the expiry date. Assuming all other factors affecting two different products are the same (underlying asset, strike price, expiry date, volatility etc.), their respective entitlement ratios would directly affect their respective values per unit. Generally, a CBBC with a higher entitlement ratio would have a relatively small value per unit. However, in theory, the entitlement ratio would not affect the performance of a particular product, as it has been calculated into the effective gearing.

The premium reflects the degree by which the price of the underlying asset needs to move before reaching the break-even price of a CBBC at expiry.

For example, if the premium of a bull CBBC is 10%, the underlying price should rise by 10% at expiry, in order to reach the break-even price.

You can calculate the premium based on the formula below (based on the payout formula at expiry):

These formulae can therefore be used as a reference to calculate the percentage by which the price of the underlying asset needs to move before reaching the break-even price of a CBBC at expiry.

These formulae can therefore be used as a reference to calculate the percentage by which the price of the underlying asset needs to move before reaching the break-even price of a CBBC at expiry.

In calculating the premium for a bull CBBC linked to the HSI based on the below formula, we need to determine the underlying price for the HSI. The spot level of the HSI may differ from its estimated future price, because the estimated future price of the HSI is calculated by reference to the sum of the cash value of the HSI (based on the HSI’s spot level) and interest rate, less the expected dividends. In most cases, as the expected dividends would be higher than the interest rate, such estimated future price of the HSI is therefore often lower than the cash value of the HSI’s spot level.

The premium calculated pursuant to the below formula may therefore be different depending on whether you apply (i) the spot level of the HSI as the underlying price, or (ii) the estimated future price of the HSI as the underlying price.

However, as the product price of a CBBC linked to the HSI is generally based on the estimated future price of the HSI futures expiring in 6 months (rather than the spot level of the HSI), such estimated future price should be adopted as the underlying price for calculating the premium of the CBBC. It is therefore likely that the premium calculated based on such lower estimated future price may result in a positive premium, whereas the premium calculated based on the spot level of the HSI may result in a negative premium, using the below formula.

Delta is the ratio of the change in the CBBC price (after adjusted by the entitlement ratio) to the change in the underlying asset’s price.

“Gearing” means the relationship that the cost of the underlying asset bears to the cost of a CBBC. For example, if the gearing for a particular CBBC is 10 times, then the investment cost of that CBBC is 1/10 of the underlying asset.

A number of other factors affecting the price of the CBBC may also change over time and, therefore, a mere rise in the underlying asset’s price may not necessarily lead to a corresponding increase to the extent of the effective gearing, or to any increase at all in the CBBC’s price.

When a listed company announces its financial results, it will also generally announce whether dividends will be paid.

Whether or not this affects the price of a related CBBC depends on whether or not dividends were expected and, if so, at what level and on what date. This is because the issuer considers past records of dividend distribution and the dividends expected by the market, when calculating the CBBC price.

Under normal circumstances, a CBBC linked to shares of a company will be adjusted if there is a capital adjustment of those underlying stocks (such as bonus issue, rights issue and restructuring event or spin-off / merger / consolidation). Specifically, an adjustment will be made to the call price, strike price and entitlement ratio according to terms specified in the relevant listing documents.

In the case of a merger/consolidation, an adjustment will be made to the call price, strike price and entitlement ratio of the CBBC of the company being merged or consolidated with. If the merger/consolidation results in an extinguishment of the current underlying, such underlying of the CBBC will change from the original underlying to a surviving/new underlying. Where there is a surviving company, no adjustment will be made to the CBBC of the surviving company.

It is possible that trading of shares of the entities undergoing a merger may be suspended for a period of time. The Listing Rules require suspension of CBBCs where the underlying stock is suspended. When this happens, the value of CBBCs may be adversely affected due to time decay during the suspension period. 

Under normal circumstances and for the purpose of calculating the value of the rights attached to the spin-off company, issuers will use volume-weighted average price (VWAP) of those auto-matched trades of that company on its first day of listing as the basis of adjustment. The adjustment will take effect from the day following the listing date. Investors should note that no adjustment will be made to those CBBCs that expire before the effective date of the adjustment.

Depending on circumstances of the case, CBBCs may be suspended from trading from the ex-entitlement date to the listing date of the spin-off company. In this case, the value of CBBCs may be adversely affected due to time decay during the suspension period.

Similarly, depending on circumstances of the case, the observation period for CBBCs may be suspended from the ex-entitlement date to the listing date of the spin-off company. Thus, no mandatory call event will occur during such period. 

In addition to the term of CBBC (i.e. underlying, expiry date, strike price and call price), the price of a CBBC also depends on a number of other factors which are based on different pricing assumptions adopted by individual issuers (e.g. different funding level, hedging cost, expected dividends, etc.). Accordingly, the prices of CBBCs with identical terms issued by different issuers may be different.

Assuming all other factors remain constant, it is likely that the bull CBBC price is affected by market force. The higher the outstanding amount, the greater the potential that the bull CBBC price is affected by market supply and demand, and as a result of which the bull CBBC price may drop due to the high selling pressure while the price of the underlying remained unchanged. 

HSI bull CBBCs are not solely priced based on HSI index. They are mainly priced based on HSI index, interest rate and expected dividend. Since HSI futures contract reflects the value of HSI index, interest rate and expected dividend, the pricing of the HSI bull CBBCs is generally priced based on HSI futures contracts.

The price of such CBBC is based on the estimated future price of the HSI futures expiring in 6 months against which the CBBC is hedged (rather than the spot level of the HSI or the future price of the front month HSI futures). The estimated future price of the HSI is calculated by reference to the sum of the cash value of the HSI (based on the HSI’s level) and interest rate, less the expected dividend. Assuming all other factors remain constant, it is likely that such increase in the spot level of the HSI was offset by the adjustment of expected dividend by the issuer, and hence the price of the CBBC remained unchanged. 

This is because the delta of the bull CBBC is not exactly equal to 1. Besides, there are a number of different factors which may affect the price of a CBBC other than underlying spot such as expected dividend and funding cost. 

When the underlying price is trading close to the call price, the price of the CBBC may become more volatile and the change in the price of the CBBC may be disproportionate to the change in the underlying price. Investors should also be aware of the number of outstanding CBBC in the market. The higher the outstanding number, the greater the selling pressure when the underlying price gets closer to the call price. This leads to a more volatile price behaviour.

A liquidity provider provides quotes for a particular CBBC by taking into consideration the prevailing market conditions such as hedging costs and the liquidity, spread and volatility of the relevant hedging vehicles. Normally, blue chip stocks have better liquidity which allows liquidity provider to provide a tighter quote than illiquid underlying.

Liquidity providers can provide bid and ask quotes at the pricing level they deem fair by reference to the theoretical price of the bull CBBC provided that they comply with the maximum spread requirements. The bid and ask spread may change from the time to time according to the prevailing market conditions affecting the underlying asset such as hedging costs and liquidity, spread and volatility of the relevant hedging vehicles.  Therefore it is possible that their quotes will not match your expected price levels due to the widening of the bid and ask spread.

For example, we assume that the theoretical price of the bull CBBC was initially HK$0.2 with a spread of HK$0.003 on each side, such that the bid and ask quotes were initially HK$0.197 and HK$0.203 respectively. The HSI then drops which leads to a corresponding drop in the theoretical price of the bull CBBC to HK$0.197. Notwithstanding the drop in the theoretical price of the bull CBBC, the spread may be widened to reflect the prevailing market conditions. For example, if the spread is then widened to HK$0.006 on each side. The new bid and ask quotes will become HK$0.191 and HK$0.203 respectively for the CBBC with a theoretical price of HK$0.197. In such case, the ask quote does not change but the bid quote is lowered due to the widened spread.

This could happen because:

1. some other pricing factors affected the bull CBBC price (e.g. expected dividend, time decay, etc.);
2. the market closing time of the bull CBBC and the underlying security was different. Being an eligible security under the closing auction session, it continued to trade in the closing auction session which ended at 4:10 p.m. while the trading in the bull CBBC ceased at 4:00 p.m. In this case, due to the 10 minutes closing time gap, direct comparison of closing price of the bull CBBC and the underlying security might not be appropriate and meaningful, or

    

3. the closing price of the bull CBBC might not reflect the quote price of the liquidity provider. In this case, quotes of the liquidity provider might have moved in line with the underlying but were not reflected in the closing price of the bull CBBC.  The closing price could be (1) calculated based on other exchange participants’ trades and quotes; or (2) carried forward from previous days.

CBBCs can be knocked out during the observation period which includes pre-opening session, continuous trading session and closing auction session. Even though the trading in the CBBC ceased at the end of the continuous trading session at 4:00 p.m., it could still be knocked out when the underlying stock hits the call price at the end of the closing auction session.

The entitlement and exercise price of the call warrant will be adjusted according to the following formula:

Adjusted entitlement = Adjustment factor * E

Adjusted exercise price = X / Adjustment factor

Adjusted call price = Y / Adjustment factor

Where

• Adjustment factor = 1 + N
• E:  Existing entitlement immediately prior to the bonus issue
• X:  Existing exercise price immediately prior to the bonus issue
• Y: Existing call price immediately prior to the bonus issue 
• N:  Number of additional shares received by a holder of existing shares for each share held prior to the bonus issue

In this case,

• Adjustment factor = 1+ 1/10 = 1.1
• Adjusted entitlement = 1 * 1.1 = 1.1 shares
• Adjusted exercise price = HK$12.28/1.1 = HK$11.164 (rounded to the nearest HK$0.001)
• Adjusted call price =HK$12.88/1.1=HK$11.709 (rounded to the nearest HK$0.001)

The purpose of the adjustment is to ensure that as far as possible, the theoretical price of the call warrant remains unchanged immediately before and immediately after the adjustment. Assuming all factors being equal, the theoretical price of the call warrant will remain unchanged.

Assuming all other factors remain unchanged, the bull CBBC price will drop upon declaration of dividend on 5 April.  It is because the actual ex-date (29 May) falls before the expiry date (14 June) and the dividend actually paid during the term of the bull CBBC is higher than expected (according to historical record it was expected that such dividend would only be paid after the expiry of the bull CBBC).